Options market information has always been important for professional traders when analysing overall market positioning. In recent times though, a specific part of this has become increasingly popular with retail traders, namely analysing the positioning of market makers.
There are many social media accounts and websites dedicated to this, both free and paid for. Some just offer data while others offer insights too.
When collecting data to judge the positioning of option market makers, these analysis accounts make a number of assumptions. I don’t want at this point to go into detail on those assumptions (I might cover them in the future) however, we need to understand that with so many assumptions, the data should be considered as less than robust. It is a simplistic overview.
Long Gamma/Short Gamma
From the data, we are told that market makers are either long gamma, short gamma or relatively flat gamma. An options trader is long gamma when they are net long options and vice versa. Long gamma traders want the underlying market to move and are helped by volatility while short gamma traders want the underlying to be stable and are hurt by increased market volatility.
For market makers, who hedge their option positions and need to rehedge when the underling moves, if they are short gamma they will rehedge in the direction of the move and when they are long gamma they will rehedge against the direction of the move.
It is important to understand that market makers only have to rehedge as a result of Gamma IF the underlying moves. They do not drive the moves, however, they might contribute to exacerbating or reducing them in certain circumstances.
Option insight accounts suggest that when option market makers are long or flat gamma, they will cause a reduction in underlying market volatility. While a large short gamma position for options market makers will cause greater volatility. This is a result of the rehedging activity. It is this topic that we will examine further on.
Vanna and Charm
Market makers may also have to rehedge if there are changes to volatility (it rises or falls) and/or over time. These are referred to as Vanna and Charm and the options insight accounts love referencing these more complex terms.
Last Week – A Classic Case of Misunderstanding Market Structure and Reflexivity
With those explanations out of the way, let’s examine one area where the options insights accounts continually misunderstand the market structure.
These accounts typically like to simplify not only the data but the effects of the information they are studying. Let’s examine an example from last week (2-5 Feb 2022) of how their misunderstanding of the information led to some wildly inaccurate market calls.
According to the (simplistic) data (with lots of assumptions), early last week, option market makers were in either a flat or small gamma position (doesn’t matter whether it was long or short). According to the many option insight accounts, this meant that equity market volatility would be low.
However, as we now know, last week saw some extremely volatile days, so the option insight accounts were obviously completely wrong. Those who acted on the prediction of lower volatility would have had some very bad P&L days.
The mistakes that were made that led to this bad call are actually quite common for retail traders and their educators. Let’s examine some:
- Believing that options market makers instigate market moves rather than react to them. The option insight accounts misunderstand the role of option market makers and their rehedging. The market makers don’t drive the initial moves, rather their rehedging reacts to the move. (Tip, the clue is in the word ‘rehedge’ -a trader only has to rehedge after a move/change of some kind). It should be obvious that markets can move or become volatile irrespective of the positioning of option market makers. There are many other participants in equity markets.
- Ignoring the role of data/earnings. Traders who use simplistic market positioning tools (technical analysis is another) often misunderstand or fail to account for the possible effect of data and earnings. Last week saw a raft of earnings announcements from major Index constituents. Failing to include this into volatility analysis is a major error. It was these announcements that drove the increased volatility. (Post Script: Just prior to sending this, the same analysis suggested on Thursday 10th Feb that volatility would be significantly reduced after equity markets had rallied into a more neutral MM gamma area. However, Feb 10th would see the release of the very important CPI number which ultimately led to a big move in equities. Another failure for this type of analysis)
- Failing to understand reflexivity in markets. There is a reflexive relationship between different participants in markets. If, for example, option market makers are flat to small long gamma it means that their counterparties (everyone else including fund managers etc) are flat or small short gamma i.e. they are not expecting a substantial move. This can mean that the counterparties are not positioned for bad earnings reports or data. When, analysing market structure and positioning it is crucial to think two or three steps ahead; how are different participants positioned and what could happen if they are wrong? Remember, the option market makers rehedging will only respond to the actions of the wider market.
A common flaw among analysis tools used by retail traders is that they assume that positioning is predictive. So if traders are long (market is going up) this is bullish etc. This is merely a short cut that enables easy market forecasts. This short cut is based on the flawed belief that markets are ahead.
- Placing too much emphasis on one form of analysis. The options insight accounts are only looking at market from the perspective of their tool. The assumption is that their analysis is the crucial one that drives the market. We see the same with those who use technical analysis tools; they see the market only through the lens of the tools they use. To coin an options term, when you use a tool in this way, you are effectively short a put option on every other form of analysis. You don’t so much have a blind-spot, you have a blind-mass!
While it is great to see retail traders trying to incorporate options data in their trading, unfortunately this form of analysis is rapidly turning into a new form of technical analysis. We are seeing the same mistakes that t/a traders make being played out in options market analysis. Simplistic use of data; use of levels such as support and resistance; a failure to account for reflexivity; market predictions rather than an assessment of risk/reward/positioning.
By all means make use of the free sites and social media accounts to investigate this data but be careful how you implement it. Make sure you consider second and third order effects and information from outside this field. In short, apply more rigorous analysis to market positioning. Don’t believe it is predictive and don’t look for short cuts and simple indicators.
Sure, options volume is much bigger now than it has ever been but it is not always going to be the driver of an underlying market.
As an interesting aside/observation, ETFs have also grown to become a huge part of markets. Many ETFs also have to rehedge daily and particularly so after larger moves. Among the ramifications of this ETF action is the possibility that ETF rehedging and options rehedging can become confused/difficult to separate.
Thanks for reading!
Happy Trading & Keep Grinding